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The Board Seat Becomes A Hot Seat

Corporate Research E-Letter No. 51, January-February 2005

THE BOARD SEAT BECOMES A HOT SEAT: NEW LIABILITY RISKS FOR CORPORATE DIRECTORS

By Philip Mattera

As members of the world’s corporate elite descended on the Swiss village of Davos this winter for their annual retreat, the conversation was not only about trade policy, energy prices and the growing power of China. According to the Wall Street Journal, top executives at the event were also voicing concerns about the seemingly mundane matter of whether they should agree to serve as directors of other companies.

At issue is not simply time management. The once common practice of CEOs to sit on the boards of a few other companies—for reasons of prestige and networking—is now viewed with trepidation. Top executives and others in the director class worry that the financial and professional rewards of board memberships are being overwhelmed by the increasing potential liability of those positions.

What put board members particularly on edge were recently announced settlements in lawsuits brought by former investors in two firms that went from being Wall Street darlings to symbols of corporate corruption: Enron Corp. and WorldCom Inc.

In the WorldCom case, ten former directors of the firm agreed to pay $18 million out of their own pockets as part of a $54 million settlement with class-action plaintiffs led by the New York State Common Retirement Fund. From the beginning of the case, investors in the now bankrupt telecom company sought to hold the directors personally responsible for failing to prevent the massive accounting fraud that took place during their watch. The $18 million figure represented about 20 percent of the aggregate personal net worth (apart from primary residences and retirement accounts) of the board members involved. Insurance carriers were to pay the balance of the settlement.

Two days after the WorldCom announcement, a group of ten former directors of Enron agreed to pay $13 million of their own funds as part of a $168 million settlement of a suit brought by investors who lost billions of dollars when the company collapsed in the wake of revelations about widespread bogus transactions and insider self-dealing.

The rarity of these settlements was underscored by Michael Klausner, a law professor at Stanford University, who told the New York Times that his research on director liability had found only four cases from 1968 to 2003 in which board members contributed their own money to settle a shareholder lawsuit. Directors are now worrying that the WorldCom and Enron cases could signal a turning point in the treatment of personal liability. “My life savings could be at jeopardy,” a director at tobacco company Reynolds American Inc. told a reporter. “It’s very scary.”

AN “IMPOTENT CEREMONIAL AND LEGAL FICTION”

In the early 20th Century there had been concern that directors who sat on various boards (a practice known as interlocking directorates) helped to solidify the ties among large companies and created the potential for anti-competitive collusion. Yet in the postwar period, power came to be concentrated in the hands of the chief executive officer. Those chosen to serve as board members were often friends of the CEO who were happy to rubber-stamp his decisions and approve generous increases in his compensation package. The fact that the board was, on paper, the ultimate policymaking body of the corporation meant little in practice. Management guru Peter Drucker once called the power of boards an “impotent ceremonial and legal fiction.”

As noted in Corporate Research E-Letter No. 3, passive boards often came under attack during the 1980s, when corporate raiders sought to shake up stodgy companies. Yet directors tended to stay loyal to management. This bond weakened in the early 1990s, when many large U.S. companies began to feel the effects of heightened international competition. As losses mounted, some boards felt compelled to act. In 1991 the outside directors of Goodyear Tire & Rubber forced out the chief executive. Even more significant was the move the following year by the board of General Motors, the country’s largest corporation, to force the resignation of CEO Robert Stempel because of the automaker’s poor performance.

The New York Times wrote at the time that “many predict that the awakening of the once sleepy GM board will redefine the cozy relationship that often exists between the nation's top executives and the hand-picked members of their boards.” It's true that in the following years the boards of other large companies such as Eastman Kodak engaged in similar coups.

Overall, however, the board revolution never materialized. The zeal of outside directors was quenched in no small part by the fact that board service had become an increasingly lucrative activity. By the mid-1990s, some large companies were paying directors annual fees of $50,000 plus stock options and other perks. For directors who served on multiple boards it was now possible to earn well into six figures from a bunch of rather undemanding part-time jobs—very part-time, given that they were usually required to attend only a few meetings a year.

As directors slipped back into their submissive and lethargic ways, they came under increasing criticism from activist institutional investors such as large labor unions. In 1996 the Teamsters published a report called America’s Least Valuable Directors that scrutinized board members based on their attendance record at meetings, potential conflicts of interest and other indicators of poor performance. That same year, Business Week published the first of what would be a series of features on the country’s best and worst boards.

These pressures helped bring about some reforms—such as demands by companies that outside directors limit the number of board seats they held—but it eventually became clear that something sinister was happening at a number of large companies, and their directors were doing nothing about it.

“A BOARD THAT RUNS DEEP”

In October 2000 Chief Executive published its own assessment of board performance. The magazine singled out for praise the directors of then high-flying Enron, calling them “a board that runs deep” and adding: “we are heartened by the overall corporate governance structure and by its governance guidelines.”

Fourteen months later, Enron filed for bankruptcy, putting thousands of employees out of work and erasing billions of dollars in the value of its stock. In the wake of that debacle came a series of revelations about other companies whose executives were alleged to have engaged in accounting frauds to enrich themselves while giving the impression that the firm was thriving.

In case after case, it was clear that board members had either failed to notice the irregularities or had somehow approved illegitimate practices. As for Enron, the evidence suggested complicity rather than obliviousness. An investigation conducted by an outside law firm found evidence that directors were well aware that executives were creating numerous off-balance-sheet partnerships. The board, in fact, had gone so far as to suspend Enron’s code of ethics in order to allow the company’s chief financial officer to participate in some of the partnerships for his personal benefit.

A 2003 inquiry into the WorldCom scandal by former U.S. Attorney General Dick Thornburgh found that the board had approved large mergers after being given only minimal information and had allowed CEO Bernard Ebbers to borrow huge sums from the company without considering whether he could repay those amounts.

Board oversight of questionable transactions (or lack thereof) has been at the center of another high-profile corporate corruption case: the prosecution of L. Dennis Kozlowski and Mark H. Swartz, two former executives of Tyco International, on charges of illegally awarding themselves hundreds of millions of dollars in bonuses and loans that were allegedly concealed from the company’s board. At the original trial of the two men last year (which ended in a mistrial) and the current retrial, the defense argued that the board knew of the lavish perks and thus no crime was committed.

Jurors will once again have to decide whether what happened at Tyco was, in effect, a case of executive larceny or board negligence. Whichever way the case goes, it will probably be of little help to the company in defending itself against the wave of civil lawsuits that have been brought by investors and former employees.

AN END TO CRONYISM?

So what do these cases mean for the future of corporate governance? The succession of business scandals that began in late 2001 brought about some changes. The Sarbanes-Oxley Act of 2002, for example, required that members of board audit committees be independent directors rather than company insiders. The New York Stock Exchange and NASDAQ now have rules that require a majority of board members at listed companies to be independent, though there is debate on how rigorously that term is being applied.

These modest reforms hardly seem adequate to address the degree of board incompetence that has come to light. The recent instances of personal liability are of greater help, but what will make a real difference is a fundamental change in the way in which board members are chosen. Only when there is an end to the cronyism that characterizes the director selection process will board independence become meaningful.

To its credit, the staff of the Securities and Exchange Commission floated a proposal in 2003 that would reform the selection process to make it easier for shareholders to nominate candidates, thus reducing the near-absolute control now held by management and incumbent directors. Unfortunately, the proposal has remained bogged down at the Commission in the face of vigorous opposition from corporate advocacy groups such as the Business Roundtable and the U.S. Chamber of Commerce.

Despite the embarrassment of scandals such as Enron and WorldCom, Corporate America appears to be doing everything in its power to keep true democracy and accountability out of the boardroom.

Violation Tracker

A database on corporate misconduct from the Corporate Research Project of Good Jobs First.